Sustainability of LAT: The NATREX Approach

Discussions regarding the appropriate exchange rate regime in Latvia have been arisen several times. There was an opinion that the depth of the recent recession and the difficulty of recovery were attributable in large part to the decision of the authorities to maintain the country's overvalued fixed exchange rate. How one can find whether the lat is overvalued or not? To what extent was the real exchange rate misaligned? The aim of the paper is to estimate the equilibrium real exchange rate of the Latvian lat using the Natural Real Exchange Rate (NATREX) approach. The author has adapted a small structural theoretical NATREX model of a small open economy and estimated econometrical model, which allows analysing the medium-term and long-term dynamics of the real exchange rate of the Latvian lat. It was shown that among other factors the Latvian lat real exchange rate was especially determined by such real fundamental factors as productivity, terms of trade, and foreign interest rates. Medium-term NATREX series are estimated and, comparing with actual real exchange rate values, medium-term misalignments are obtained and analysed in the research.